The Importance of Having a Capital Expense Budget when Buying a Property

One of the biggest mistakes I see investors make when financially evaluating an investment property is that they fail to include a capital expense budget for the property. When acquiring an investment property, it is critical that you have a capital expense budget as well as a recurring replacement reserve factored into the equity you will need to acquire the property and operate it effectively.

What is a capital expense budget?

A capital expense budget is a one-time amount that should be budgeted for when acquiring a property. This is a repair expense or an expense to upgrade key components of the property that cannot be covered by the typical recurring replacement reserve that is funded out of the property’s operations. A capital expense budget will help you avoid major expenses later on, or can be allocated to projects that can increase your ability to raise rents, lower expenses, and increase the value of the property. Each property is different, so it is your job to identify these items when you do your evaluations as they can greatly affect the returns on your investment dollars.

What should be included in the capital expense budget?

When we identify the items to include in our budgets, we look for items that are failing now or that could fail within a 3-5 year period. We also look at items that we can take care of immediately that will help us to increase rental rates or make it easier to lease or manage. Key items to look for and include in this budget are roof replacement, foundation repairs, deck replacements, landscaping, cabinets or appliance upgrades, flooring and paint to name a few. If you have a contractor on your team, they can be essential in helping you identify these items before putting in your offer. Failing to account for these capital budgets and recurring replacement reserves can leave you scrambling for cash when these items need to be repaired or replaced.

How is a capital budget different from a recurring replacement reserve?

A capital budget is different than a recurring replacement reserve because it is for major items that you have identified that you either want or need to take care of immediately, which you wouldn’t have the money to fund out of the operating expenses of the property. The replacement reserve is for recurring replacements that you will have to take care of on a normal basis such as replacing flooring or old appliances that have reached their end of life, and replacing items such as air conditioners or roofs several years down the road. The replacement reserve allows you to set aside money for future expenses that you know will occur so that you have the money to take care of them when they do happen.

Why do I need both a capital expense budget and a recurring replacement reserve?

A capital expense budget and a recurring replacement reserve are extremely important to have on any investment property. They allow you to account for future expenses up front when determining the investments return and offer price. They also allow you to plan how to take care of key items that will help you lease, increase rents, and manage your investment property more effectively and efficiently.

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About Author

Spencer Cullor has spent the last 10 years as a real estate investor and currently owns single family, multifamily apartments, and commercial properties with his investment partners. Currently he is the Director of Acquisitions and Principal of ApartmentVestors, a multifamily real estate investment company.

Spencer,
Thanks for the advice. Setting aside a budget for capital expenses on a new rental investment essential. As you suggest, this should definitely be planned during the early stages when evaluating how much you are willing to pay for a property. If figured out ahead of time it certainly will give you a clearer picture on how much you actually are going to pay for a property considering the work will need to be done. In my experience it also gives you a stronger mental ability and possible more leverage when negotiating a purchase price especially if the capital improvements are extensive. Additionally, planning a recurring expense reserve is smart advice and one that I am sure gets overlooked.
Thanks again for the input

Thank you for your comment Steve, you are right on. Knowing the capital expenses up front or at least a good portion of them (some you can only find when you walk through the units) does put you in a stronger negotiating position with the Seller. We’ve used it several times to our benefit when negotiating deals. Occasionally, you will get an investor that hasn’t seen the property or that doesn’t have a clue on the capital expenses and outbids you initially, but then the contract falls through when they discover the extent of what needs to be done and when it falls through, the Seller will call you to see if you are still interested and then you have all the leverage. We see it happen all the time.

Thanks for reading and commenting and I look forward to posting more articles soon.

I’ll get out that article right away. As for the capital expense and recurring replacement reserves, we put them in an interest bearing account so we know it will be there when we need it. With the capital expense budget we are usually planning on spending that money right away when we take over a property and want to make sure it’s liquid and ready to go so we can get the very best deals with contractors. With the recurring replacement reserve a lot of financing institutions will make you escrow that money and then get reimbursed out of it because they want to make sure it’s there when you need it and they are trying to protect the asset. If the lending institution doesn’t escrow the money it is a good idea to put it in a separate account that is interest bearing, but secure so that you don’t spend it as a part of regular expenses and also so it is there when you need it. I wouldn’t recommend lending it out as a PML as it might not be available when you need it and then you are stuck trying to figure out how to get the money to do the repairs.

Spencer,
I have recently taken a position with a private equity group that has commercial real estate in the portfolio and have been trying to convince them to establish a capital escrow account for each property to fund future capital improvements. Do you know what is the industry standard – a percentage of EBITDA, rental income, operating income, etc . I am looking for seom benchmarks to use
Thank you advance

Good question Bob. Most mortgage brokers will factor in $250-$300 per unit on an annual basis for a capital budget. Others like to use 1% of the purchase price per year. Here is another article I wrote on this very subject.